October 2009 - Economic Recovery, Jobs, and Government Stimulus

It appears the US economy has returned to growth. The manufacturing sector grew in August while the services sector began to grow in September. Second quarter GDP growth was just -0.7%. Debate will now shift, and markets will in part be driven by developments related to the monetary and fiscal stimulus measures implemented by the Federal Reserve and the Federal Government.

Fiscal Stimulus

Fiscal stimulus is the use of government spending or tax incentives to "prime the pump" of the economy. The strategy relies on the belief that spending on infrastructure projects or channeling activity through tax incentives will create a "trickle down" effect, creating jobs, which create consumption, which culminates in a positive feedback loop. The US stimulus package of $787 billion is approximately 5% of GDP and is similar in size to packages being implemented throughout the developed world. A modest debate has emerged, focusing on public vs. private sector efficiencies, around the immediate effects of fiscal stimulus packages. However, the greater debate concerns the long term effects of debt financed fiscal stimulus that must be paid for through taxation. If all goes well, a larger economy will generate increased tax revenues. To date, the US government has announced $308 billion in stimulus spending, and paid out $107 billion of the package.

Monetary Stimulus

Monetary policy is the attempt by a central bank to stimulate or cool an economy through the use of interest rates, currency in circulation, or emergency lending. Central banks around the world have aggressively implemented all three types of policy. When a central bank implements expansionary monetary policy, its balance sheet will expand.

Balance Sheet of the US Federal Reserve
Source: US Federal Reserve

The US Federal Reserve began lowering short term interest rates in the fall of 2007. When it became clear this policy was not sufficient, the Fed implemented emergency lending programs that caused its balance sheet to balloon. Fortunately, these facilities are now contracting. The Term Auction Credit Facility, which provides collateralized loans to banks, has come down from $500 billion to $178 billion as of October 1. Primary, Secondary, and Dealer programs were also expanded during the crisis and now all stand at a fraction of their highs. The Fed also extended credit to AIG. That $60 billion balance has been paid down to $38 billion. The Fed came to the aid of the money markets after the now infamous “breaking of the buck.” The commercial paper markets were extended credit of $340 billion; this facility now has less than $42 billion outstanding.

Purchasing or selling securities in the open market is a central bank process to affect currency in circulation. The Fed has committed to purchasing $1.25 trillion in agency mortgage securities, $200 billion in agency debt, and $300 billion worth of US Treasuries. This has the effect of lowering interest rates and increasing the amount of money supply in the economy – a strategy that can lead to inflation. The Federal Reserve has announced a plan to combat the inflationary effects, should they occur, by selling reverse repurchase agreements for a specific period. This tactic would, in theory, put a floor below the prices of these securities, keep interest rates low, and prevent inflation.

To be sure, the next several quarters will be interesting as markets and investors digest the wind down of fiscal and monetary support. Investors need to watch economic data closely to see how well the handoff from public to private sector develops.

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